1. MVP Inc., a manufacturing firm with no debt outstanding and
a market value of $100 million is considering borrowing $ 40 million
and buying back stock. Assuming that the interest rate on the
debt is 9% and that the firm faces a tax rate of 35%, answer the
following questions:

a. Estimate the annual interest tax savings each year from the
debt.

b. Estimate the present value of interest tax savings, assuming
that the debt change is permanent.

c. Estimate the present value of interest tax savings, assuming
that the debt will be taken on for 10 years only.

d. What will happen to the present value of interest tax savings,
if interest rates drop tomorrow to 7% but the debt itself is fixed
rate debt?

2. A business in the 45% tax bracket is considering borrowing
money at 10%.

a. What is the after-tax interest rate on the debt?

b. What is the after-tax interest rate if only half of the interest
expense is allowed as a tax deduction?

c. Would your answer change if the firm is losing money now and
does not expect to have taxable income for three years?

3. WestingHome Inc. is a manufacturing company, which has acccumulated
an net operating loss of $ 2 billion over time. It is considering
borrowing $ 5 billion to acquire another company.

a. Based upon the corporate tax rate of 36%, estimate the present
value of the tax savings that could accrue to the company.

b. Does the existence of a net operating loss carry forward affect
your analysis? (Will the tax benefits be diminished as a consequence?)

4. Answer true or false to the following questions relating to
the free cash flow hypothesis.

You can assume that earnings and free cash flows are highly correlated.

6. Nadir, Inc., an unlevered firm, has expected earnings before
interest and taxes of $2 million per year. Nadir's tax rate is
40%, and the market value is V=E=$12 million. The stock has a
beta of 1, and the risk free rate is 9%. [Assume that E(Rm)-Rf=6%]
Management is considering the use of debt; debt would be issued
and used to buy back stock, and the size of the firm would remain
constant. The default free interest rate on debt is 12%. Since
interest expense is tax deductible, the value of the firm would
tend to increase as debt is added to the capital structure, but
there would be an offset in the form of the rising cost of bankruptcy.
The firm's analysts have estimated, approximately, that the present
value of any bankruptcy cost is $8 million and the probability
of bankruptcy will increase with leverage according to the following
schedule:

Value of debt Probability of failure

$ 2,500,000 0.00%

$ 5,000,000 8.00%

$ 7,500,000 20.5%

$ 8,000,000 30.0%

$ 9,000,000 45.0%

$10,000,000 52.5%

$12,500,000 70.0%

a. What is the cost of equity and WACC at this time?

b. What is the optimal capital structure when bankruptcy costs
are considered?

c. What will the value of the firm be at this optimal capital
structure?

7. Agency costs arise from the conflict between stockholders and
bondholders, but they do not impose any real costs on firms. Comment.

8. Two firms are considering borrowing. One firm has excellent
prospects in terms of future projects and is in an area in which
cash flows are volatile and future needs are difficult to assess.
The other firm has more stable cash flows and fewer project opportunities
and predicts its future needs with more precision. Other things
remaining equal, which of these two firms should borrow more?

9. How would you respond to a claim by a firm that maintaining
flexibility is always good for stockholders, though they might
not recognize it in the short term?

10. A firm that has no debt has a market value of $100 million
and a cost of equity of 11%. In the Miller-Modigliani world,

a. What happens to the value of the firm as the leverage is changed?
(Assume no taxes)

b. What happens to the cost of capital as the leverage is changed?
(Assume no taxes)

c. How would your answers to (a) and (b) change if there are taxes?

11. XYZ Pharma Inc. is a pharmaceutical company that traditionally
has not used debt to finance its projects. Over the last 10 years,
it has also reported high returns on its projects and growth,
and made substantial research and development expenses over the
time period. The health care business overall is growing much
slower now, and the projects that the firm is considering have
lower expected returns.

a. How would you justify the firmís past policy of not using debt?

b. Do you think the policy should be changed now? Why or why not?

12. Stockholders can expropriate wealth from bondholders through
their invesment, financing and dividend decisions. Explain.

13. Bondholders can always protect themselves against stockholder
expropriation by writing bond covenants. There is, therefore,
no agency cost associated with the conflict between stockholders
and bondholders. Do you agree?

14. Unitrode Inc., which makes analog/linear integrated circuits
for power management, is a firm that has not used debt in the
financing of its projects. The managers of the firm contend that
they do not borrow money because they want to maintain financial
flexibility.

a. How does not borrowing money increase financial flexibility?

b. What is the trade-off you would be making, if you have excess
debt capacity, and you choose not to use it, because you want
financial flexibility?

15. Consolidated Power is a regulated electric utility which has
equity with a market value of $ 1.5 billion and debt outstanding
of $ 3 billion. A consultant notes that this is a high debt ratio
relative to the average across all firms, which is 27%, and suggests
that the firm is overlevered.

a. Why would you expect a electric utility to be able to maintain
a higher debt ratio than the average company?

b. Does the fact that the company is a regulated monopoly affect
its capacity to carry debt?

16. Assume that legislators are considering a tax reform plan
which will lower the corporate tax rate from 36% to 17%, while
preserving the tax deductibility of interest expenses. What effect
would this tax reform plan have on the optimal debt ratio of companies?
Why? What if the tax deductibility of debt were removed?

17. Governments often step in to protect large companies that
get into finanical trouble and bail them out. If this is an accepted
practice, what effect would you expect it to have on the debt
ratios of firms? Why?

18. The Miller-Modigliani theorem proposes that debt is irrelevant.
Under what conditions is this true? If debt is irrelevant, what
is the effect of changing the debt ratio on the cost of capital?

19. Based upon the financing heirarchy described in this chapter,
what types of securities would you expect financially strong firms
to issue? What about financially weak firms? Why?

20. In general, private firms tend to take on much less debt than
publicly traded firms. Based upon the discussion in this chapter,
how would you explain this phenomenon?

21. There is a significant cost to bankruptcy since the stock
price essentially goes to zero. Comment.

22. Studies indicate that the direct cost of bankruptcy is small.
What are the direct costs? What are the indirect costs of bankruptcy?
What types of firms are most exposed to these indirect costs?

23. When stockholders have little power over incumbent managers,
firms are likely to be underlevered. Comment.

24. The following graph summarizes the debt ratio of Xerox from
1970 to 1995.

a. How would you explan the increase in leverage from the 1970
to 1995?

b. What general lessons would you draw for high growth firms today?

25. Debt is always cheaper than equity. Therefore, the optimal
debt ratio is all debt. How would you respond?